Saturday, 29 June 2013

Evaluation of Cap and Trade in the Context of the EPA Acid Rain program

In many countries Cap and Trade policies are seen as revolutionary. These types of programs have actually been in existence for decades in different forms and we can learn much from the outcomes.

Title IV of the Clean Air Act amendments of
1990, the Acid Rain Program (Title IV) was the world’s first, and is still the
foremost example of a Cap-and-Trade program. As such, the program was highly
anticipated and has been a benchmark for subsequent policy responses to
environmental issues. This report identifies the issues that Title IV sought to
resolve, develops an understanding of the economic principles that are involved
in the policy, and ultimately explores whether this was, in fact, good policy

Title IV sought to address concerns around
health and environmental impacts of Sulfur Dioxide (SO2). Policy makers are
particularly concerned when SO2 in the environment is absorbed by vegetation or
soil, is dissolved into water (Albeta Environment,
2003)
or when SO2 reacts with other compounds to form small particles which penetrate
the lungs of animals including humans. These particles can lead to respiratory
disease, heart disease and premature death (EPA, 2012). The impacts on
wild-life are often indirect and caused by changes to an animal’s ecosystem,
such as impact on levels of selenium in plants (WHO, 2000).

The purpose of a policy instrument that
seeks to manage environmental impact is to balance environmental improvements
with the most economically efficient abatement measures which have the most
positive social impacts. In addition, the aim is improve products and processes (Common, 2005). As a market
mechanism it should also strive to provide certainty, liquidity (Chan, 2012), flexibility,
distributional efficiency (geographic and temporal) and have reasonable
transaction fees (Sovacool,
2011).
In this case the key polluters were power stations, and as such mechanisms
needed to be designed specifically to manage the Marginal Abatement Costs (MAC)
and Marginal Damage Function (MDF)associated with these assets.

Cap-and-Trade is essentially a market response to an environmental problem. As
such the mechanism is grounded in economic theory. Many perceive the benefits
of Cap-and-Trade mechanism are that it combines the positive attributes of
command and control, in the setting of absolute targets, with the efficiency of
a market instrument. The policy also seeks to manage the following key
requirements.

Calculating the target

When this policy came into being there was
no way to clearly model the Marginal Damage Function (MDF) and the Marginal
Abatement Cost Function (MAC). Rather the target was based on what was seen as
being abatement that could be achieved cost effectively, and above which costs
would climb exponentially (Schmalensee, 2013).

An initial cap was set at 9.97 (m) tons SO2e
on 263 of the most polluting power stations. It then was to reduce to 8.95 (m) tons
SO2e in year 2000 on approx 3,200 generating units (Chan, 2012), which is a
reduction of 50% from 1980 levels.

Determination of least cost abatement

The key benefit of Cap-and-Trade is that it
should, in theory, drive the lowest market wide cost of abatement. By allowing
trading in allowances, the program enables the market to identify those
individual firms with the least cost abatement opportunities and then these
firms trade their allowances with firms with higher cost of abatement.

Originally pundits evaluated the success of
the scheme by comparing ex-ante estimates of abatement costs in a theoretical
least cost solution. To build a realistic evaluation of success you need to
employ scenario modeling that accounts for the impact of variables such as
technological change and fuel price movements (Carlson, 2000) and then discount
value of compliance costs over time. Other economic concepts that feed into
this equation include decisions around labor, capital investment, fuel costs
(high and low sulfur content fuel), cost of production, emission rate, rate of
retirement of existing capital and time period (Carlson, 2000). As factors outside
of the program influence the MAC the benefits of allowances and trading change
to the positive or negative..

It is also important to differentiate
between compliance costs (which are relatively easy to measure) and true
economic costs (which are often missed in evaluations). Economic costs are the
value of goods and services lost due to regulation. For example increased
product prices will effectively lower real wages and therefore decrease
consumption. (Burtraw,
1998)

Managing temporal issues – banking,
auctions and futures markets

Economic concepts are also employed to
manage “inter-temporal arbitrage” (Burtraw, 1998). There have been two
tools employed in Title IV to manage this phenomenon – banking of credits and
futures trading in allowances. Both allow industry to determine when the MAC
will be minimized given changes in capital, labor, fuel and other costs.

Managing geographic issues

Perhaps one of the most keenly debated
economic features of this type of policy is the management of dispersion. It is typically assumed that command and
control policies are beneficial where issues are location specific, and Cap-and-Trade
is more appropriate where they are dispersed. SO2 has characteristics of both
which made dispersion a more complex issue and resulted in b-spoke solutions
that often pitted the Cap-and-Trade scheme against existing local regulations
and schemes (Chan, 2012).

What are the potential outcomes of the policy (from an “inter-disciplinary”
perspective")?
Is this ‘good’ policy?

Many articles, both past and more recent,
laud the success of this scheme. The report by Harvard Business review outlined
that the schemes was “ a success by all measures” (Chan, 2012, p. 5). To fulfill this
promise it should (according to definitions) maximise environmental benefit at
the least social cost.

A common figure for the health benefits of
the program was $142 B, which is a significant saving as against the costs outlined
by (Burtraw, Cost Savings,
Market Performance, and economic benefits of the U.S Acid Rain program, 1998). A particular
success was the flexibility of the scheme, as industry adopted unexpectedly
wide range of mitigation strategies to minimize their MAC (Sovacool, 2011). Another positive
surprise were the incredibly high compliance rates of 99.9% (Napolitano, 2007). And there were many
other benefits such as the fact that emissions did not rise with economic
prosperity, the scheme was seen as transparent, liquidity did emerge after a
point, and banking of credits reduced uncertainty.

The core argument from detractors of the
scheme is not as to whether there were environmental benefits, but rather
whether these benefits were based on the scheme driving the lowest costs of
abatement. As identified above, the actual MAC is based on changing
technologies, fuel prices and changes to other inputs to power generation (such
as transport costs (Schmalensee, 2013)). Many argue that
positive movements in these factors drove reductions in SO2 rather than the
cap. By reducing the MAC it is easier to achieve the cap and reduction in
spatial differences, (including transport costs), have made cost curves more
homogenous. Both of these developments have lowered the benefits of trading
allowances (Carlson, 2000).

Other issues that have emerged in this
policy include: generating units were able to pass costs onto consumers; a
monopoly developed in the market futures contracts (Jaffe, 2009); there were market
distortions caused by over-compliance in early years (Burtraw, 1999); the initial
allocation of allowances was often based on lobbying rather than economic
principle; the sum of the market value of allowances exceeded the total
abatement costs due to the cap being too high (Chan, 2012); there were some
challenges with the equity of pollution, as emitters that bought permits
continued to pollute in some areas and the impacts of pass-through pricing hit
lower income earners disproportionately; there are challenges assessing the
true cost at the margin if energy generated by coal is not the most expensive
form of generation (Carlson, 2000); in 2005 the price
of allowances initially inflated and then dropped to near zero as insurmountable
conflicts emerged between this market based and traditional policy measures (Chan, 2012).

Perhaps the most burning social and
environmental questions arise from the potential inappropriateness of
discounting environmental damage, and the initial basis for determination of
the cap; which were the perceived acceptable costs of mitigation, rather than
the benefits that could have been accrued based on the related opportunity
costs of the damage. This raises serious questions around the ongoing
perception of the marginal damage caused and therefore the real (i.e
discounted) opportunity cost of Acid Rain.

Title IV was a groundbreaking policy
initiative that was pushed by neo-liberal politicians as a market response to the
increasing impacts of Acid Rain. While many questions remain regarding whether
this was the least cost method of abatement on a systemic basis, and whether it
really avoided appropriate levels of marginal damage, this was brave policy and
enabled future policy makers and environmentalists to better understand the
mechanics of a Cap-and-Trade response. For this alone it was good policy.

Hahn, R. (2010). The effect of allowance
allocations on Cap-and-Trade system performance. Cambridge: National Beuro of
economic research.

Jaffe, S. (2009, March 27). SO2
Allowances Price Drop : Is there a lesson here? Retrieved May 5, 2013, from
Law and the Environment:
http://www.lawandenvironment.com/2009/03/so2-allowance-prices-drop-is-there-a-lesson-here/

Napolitano, S. (2007). The U.S. Acid Rain
Program:Key Insights from the Design,Operation and assessment of a
Cap-and-Trade System. The Electricity Journal , 47-58.